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January 1, 2006

Pray for Warm Weather

When Hurricanes Katrina and Rita rampaged through the Gulf of Mexico, they upset an already tottering supply and demand structure for natural gas. The implications—both in pricing and possible supply interruptions—are staggering for the short term. But the silver lining, if there is one, may be a long-overdue focus on a problem that has been quietly building for many years.

Before Hurricanes Katrina and Rita slammed the Gulf Coast, natural gas prices already had risen to record levels, driven by the inexorable market forces of supply and demand. Demand is on a slow but steady upward curve, driven by the growing usage of this fuel in homes, businesses and gas-powered utility plants, while supply remains stagnant.

Despite increased drilling, domestic gas fields are mature and their yield is declining, while new exploration is failing to uncover substantial new supplies. Capacity for imports, which constitute only 15% of supply, are limited. The four continental U.S. facilities for handling imported liquefied natural gas (LNG) are operating near full capacity.

Coupled with a warmer than normal summer, which increased consumption by gas-fired electric generating plants operating at peak capacity to meet cooling demand, these factors pushed prices to record levels in early August, and many analysts warned that high natural gas prices would become the norm.

Their predictions took on new meaning in the weeks after the pair of devastating hurricanes
hit the Gulf Coast. From a pre-Katrina price of about $10 per thousand cubic feet, spot natural gas prices soared above $14, more than double the year-ago level, as reported in a daily update from the Energy Information Administration, “Hurricane Impacts on the U.S. Oil and Natural Gas Markets.”

“Before either hurricane hit the Gulf, we were already facing a very serious energy supply problem,” says Andrew D. Weissman, senior managing director of FTI Consulting Inc. in Washington, D.C., and publisher of Energy Business Watch, a subscription newsletter that provides energy customers, users, traders and hedge funds with updates on natural gas supply and pricing issues. “The likelihood was that supplies would get tighter and prices go higher. The hurricanes have taken a big bite out of supplies and intensified an increase in price that was going to happen anyway.”

Still, the extent of the hurricanes’ impact on natural gas supplies stunned energy experts and utility executives. Offshore drilling rigs and onshore natural gas processing facilities suffered from the one-two punch of the storms.

In the days immediately following Rita’s hit on the Gulf, 72% of the region’s natural gas production was shut-in, and 26 gas processing plants were disabled. A gradual recovery hit yet another setback when some rigs were evacuated in the face of Hurricane Wilma in October. Altogether, 192 oil and gas drilling rigs and production platforms were damaged, set adrift or sunk by the hurricanes. By the end of November, 30% of the Gulf production remained closed down and several processing plants still were out of commission. Between the time that Katrina hit in late August and the start of December, 14% of the annual production of gas from the Gulf had been lost, according to statistics from the Department of Interior’s Minerals Management Service.

While news reports focused on the good news that Rita largely spared the Texas oil refineries, natural gas experts were sounding the alarm about widespread damage to the natural gas infrastructure in a region that produces 20% of the nation’s supply.

“It is safe to say that two major hurricanes striking back to back at the heart of our nation’s energy system have caused an unprecedented disruption in our Gulf-based natural gas infrastructure,” Christopher A. Helms, president of the pipeline group of Indiana-based natural gas supplier NiSource, Inc., told the Senate Energy and Natural Resources Committee in October. “Given the tight supply/demand situation we were already facing before the hurricanes, this loss of supply—even temporarily—is a cause for concern as we approach the winter heating season.”

His concern is based on the fact that the hurricane-related shutdowns slowed the usual building of inventory during the fall season, when usage typically drops between the cooling and heating seasons.

On November 30, natural gas in storage was at 3,170 billion cubic feet (bcf), 74 bcf lower than one year earlier, according to the Energy Information Agency (EIA). While that may seem an insignificant difference, the need for the gas in reserve may exceed last year’s demand. The great unknowns are how long it will take to get natural gas from the Gulf fully flowing through the pipelines again and just how severe the winter will be. The National Oceanic and Atmospheric Administration (NOAA) predicts that this winter will be 6.5% cooler than last year, putting a bigger drain on supplies.

Large users often get lower prices for natural gas by agreeing to temporary curtailments if their supplier has a shortfall. For metals companies with interruptible contracts, there is an increased likelihood of service interruptions this winter.

“We will start the winter with less gas in storage than last year,” says Barbara Mariner-Volpe, an EIA analyst who specializes in industrial natural gas supplies. “Depending on the weather, there likely will be periods when interruptible contacts will be interrupted. The wild card is the weather.”

While the EIA does not forecast the likely number of days interruptions might occur or quantify expected impact by region of the country, Mariner-Volpe says the Northeast, especially New England, is the most vulnerable because the area has few indigenous supplies and no natural gas storage facilities.

Neither the government nor industry associations has statistics on what percentage of industrial contracts are interruptible, but Jennifer Deegan, director of energy markets for the Natural Gas Supply Association (NGSA), says most are. She points out that there are many types of contracts and in some, interruptions are anticipated, even in a normal winter. The extent of concern by suppliers about this winter, however, is reflected by the association prediction that interruptible customers can anticipate interruptions.

The NGSA has told federal regulators that the best way to assure that suppliers can meet critical home heating needs is for the government to stay out of the picture.

“Even in the most colder-than-normal weather scenarios, we believe a resulting spot market price spike would temporarily lead sufficient industrial demand off the system to assure essential heating for homes, offices and all public services. In this way, markets always have proven to be the most effective way to allocate resources during times of scarcity,” NGSA president and CEO Skip Horvath told a Federal Energy Regulatory Commission (FERC) hearing in October.

$10 FOR THE REST OF THE DECADE

Beyond the immediate crisis is a larger problem with no easy solutions. The EIA predicts Gulf Coast production won’t be fully restored until the end of the second quarter of 2006, and natural gas prices will remain above the pre-hurricane level of $10 per thousand cubic feet through the winter heating season—five times the 1999 price. In November, the EIA forecast prices to then decline through the second half of 2006, averaging $9 for the year, lower than the $9.15 average price estimated for 2005. However, the EIA warned that if the winter is even 10% colder than predicted, prices will go significantly higher.

H. Sterling Burnett, senior fellow at the National Center for Policy Analysis in Dallas, predicts prices will stay near the $10 range for the rest of the decade. “For the next five years, there is not a lot of hope,” he says. “The things that need to be done should have been started five or more years ago.” He blames Congress for failing to act when President George W. Bush first proposed comprehensive energy legislation in 2001 and for omitting some key elements of the president’s plan when an energy bill finally passed last summer.

The experts hope the hurricanes serve as a wake-up call to government and Congressional leaders who have been slow to act and beholden to special interests.

“The natural gas supply situation poses a substantial risk to the U.S. economy,” Weissman says.

“We need to say this is a time of emergency,” Burnett says. “To the extent that politics is slowing our growth rate, it’s time for politics to get out of the way.”

Natural gas trade associations and outside experts agree that urgency should first be focused on significant conservation efforts—the only way to impact prices in the near term, given the long lead times for expanding production and LNG import capacity.

“Conservation can be as simple as customers installing programmable thermostats or turning their thermometers down merely two degrees from their usual setting,” says Horvath. “These measures will be the most effective, efficient and money-saving precautions customers can take to alleviate any further heating season impacts.”

LONG-TERM ECONOMIC IMPACT

The answer to what else is needed differs among analysts, but they agree that the hurricanes underscored the danger of putting all our energy eggs in the Gulf Coast basket.

Yet most additional construction of LNG terminals for imported natural gas—viewed as critical for meeting U.S. energy needs into the future—is slated for that same region, largely because of strong opposition to the terminals on the East and West coasts.

Kevin Forbes, director of the Center for the Study of Energy and Environmental Stewardship at Catholic University, and a member of Stanford University’s Energy Modeling Forum, which brings together experts from government, industry and academia to discuss critical energy issues, suggests diffusing the opposition by providing substantial property tax relief incentives for homeowners in communities that agree to LNG terminal construction.

Forbes also supports expediting construction of a natural gas pipeline from Alaska, currently scheduled for completion in 2015, that could bring 4 to 6 bcf of gas per day to the lower 48 states. “A lot of red tape associated with that project is holding it up,” Forbes says. “This delay will disproportionately impact the industrial customer, who will pay the price in service disruptions.”

Forbes favors establishment of a Strategic Natural Gas Reserve, similar to the Strategic Petroleum Reserve, which the president could tap to alleviate the kind of energy crises generated by the hurricanes.

“Now we have to pray for warm weather, and with all due respect to the power of prayer, it shouldn’t come down to that,” he says. “We should have an adequate (reserve) supply in our hip pocket.”

Burnett advocates opening up more public lands for drilling. To mitigate the potential for lawsuits blocking both drilling on public lands and pipeline construction, he suggests replacing regulatory barriers with a bond requirement that would pay for restoring any environmental damage. He also says federal intervention to acquire land for pipeline construction may be needed, with compensation for landowners at a premium to market value.

Weissman says the needed changes are far broader.

“What we are talking about is a fundamental shift from an era of abundant energy to an era where energy is expensive,” he says. “We need to replace equipment and infrastructure, develop new technologies and make major structural changes in our habits. The health of the U.S. economy depends on whether we recognize the need to make the transition quickly. We can either become the world leader in using energy efficiently, or we can ignore the trends and watch our economy get weaker and weaker every year.”